Investing in ETF’s (Exchange Traded Funds) and Index Tracking Funds

Financial Planning

Investing in ETF’s (Exchange Traded Funds) and Index Tracking Funds

What is an ETF?

Exchange traded funds, often known as ETF’s, are a special type of mutual fund that trade on an exchange in the same way that an equity does. They can provide small discounts to underlying net asset value in volatile markets. ETFs and index tracking funds help passive investors keep their investing decisions simple.

So, what is the difference between an ETF and an index tracker?

They are both passive investments that replicate the movement of an index. However, the main difference between them is based on investment flexibility. ETF’s are traded on stock exchanges, so their price can change constantly, and they can be bought and sold, just like shares. Investors get a set price that reflects the underlying index at the point that they buy or sell. Tracker funds however, are structured as a unit trust or open-ended investment company (OEIC), building a portfolio reflecting an index, and priced once a day. Investors wanting maximum flexibility – to buy and sell the fund many times in one day will find ETFs the most suitable vehicle, whereas tracker funds may be more competitively priced and make only periodic investments.

Another major departure is that an ETF doesn’t necessarily hold the securities of the index it claims to track. One can have a physical ETF as well as a synthetic ETF. Physical ETFs do hold the assets of their index, either replicating the index in full or sampling a proportion. On the other hand, synthetic ETFs use derivatives to track an index. This is a complicated process, and the result is meant to reduce cost and tracking errors, but they do increase counterparty risk. (if the intermediary derivatives lender goes bankrupt, for example) For this reason, they are generally considered higher risk.

The attraction of an ETF is that they are appealingly low-cost in fees and require very little to no effort to maintain in your portfolio. Instead, computer algorithms do all the transactions, sticking to the chosen index. For capital growth, passive investments are a great low-cost strategy and statistically beat active investing strategies over the long term.

Some examples of the least cost index trackers available are the Fidelity Index UK Fund P with a Total Expense Ratio of 0.06% or the HSBC FTSE All Share Index C, at 0.07%.

Passive vs Active Investment

Passive investing, by definition, involves much less time analysing stocks or picking winning companies. Instead, the investor invests in an ETF (usually an index tracker) to reap the rewards of the market. It is very simple for those with little investment experience – a sound strategy for any beginner investor would be to simply construct a diversified portfolio made up of several different index funds, while making regular contributions and rebalancing the portfolio every so often.

However, there are also many benefits to the active investing style. Active funds can be opportunistic, meaning that the right fund can make relatively higher returns from exploiting a market imbalance. As passive funds have a mandate to buy a fixed basket of assets as more money flows into it, more cash is allocated to the same stocks which then may become overvalued. As Index Trackers have been growing in popularity recently, one could argue that investors are just buying a basket of overvalued equities, whereas Active Managers have the potential and flexibility to search for better values elsewhere.

Active funds are also considered to be better than bonds and fixed-income investments, because index funds haven’t yet caught on in the bond world. It is difficult to choose what bonds to buy in a passive fund – if it is done on market-cap/size of the total bond, then the company will be riskier and less likely to pay back its debt, so this classification is not attractive.

Active managers are much more flexible to adapting to the bond market and for identifying yield opportunities. This can allow them to build a much more diversified portfolio than if they were to just stick to equities. Moreover, active funds can be diversified and tailored to individual needs, and more importantly can outperform index trackers when the market does badly, as managers can use hedging techniques.

As with any investment decision, different investment styles suit different investors. Significant value can be added to your savings by talking to a qualified advisor at Credence International.